If banks are treated as naughty kids...

As the Parliamentary Commission on Banking Standards today applies new pressure on the chancellor to legislate for banks to have lower maximum leverage ratios, it is worth reminding ourselves why this matters.

Leverage is the ratio between what banks lend and invest on the one hand and the capital they hold to absorb potential losses on their loans and investments.

So all else being equal, which they never are of course, a bank with a lower leverage ratio is a safer bank, because it has relatively more capital to protect depositors from losses.

But that doesn't necessarily mean that you should always place your precious savings in the bank with the lowest leverage ratio: the bank with the low ratio might be lending and investing in a particularly reckless and risky way; although it might have more capital than other banks, its losses might turn out to be massively bigger than those other banks.

That's why a low leverage ratio is not a guarantee that a bank is safe. In fact a bank with a leverage ratio of infinity run by individuals with god-like knowledge of the true risks of lending would be safer than a bank run by mortals whose leverage ratio is tiny.

Here are the important points: riskier loans and investments provide bigger rewards to banks, until the loans and investments go bad; and capital is expensive for banks.

Which is why governments did not trust banks to behave prudently if they were subject to a simple gross leverage restriction. The assumption was that if every bank was told it could not lend - for example - more than 20 times its capital, large numbers of those banks would lend everything they could to reckless gamblers prepared to pay the highest interest rates, till gamblers and banks went bust.

Instead governments hired regulators to check that banks were not taking insane risks. And the regulators invented the Basel system of risk-weighted capital ratios, which stipulates different leverage ratios for different categories of loan, in theory to take account of the riskiness of those loans.

To put it another way, governments set up a system that in effect treated bankers as naughty children or ravenous puppies who could not be trusted not to eat too much of the dangerously fattening stuff - and regulators were to be the health conscious parents.

The perhaps predictable result is that the bankers lived up to the low expectations of their common sense, and devised ever more clever ways to raid the biscuit tin without being seen. And the regulators turned out to be the worst kind of parents: ignorant of what was really happening in the world; prescriptive in all the wrong ways.

Under the Basel system, regulators ordained - for example - that banks could lend more relative to their capital if they were providing mortgages to house buyers than they could if they were lending to a giant multinational company: regulators deemed it was less risky for a bank to provide you with a mortgage than to lend to Tesco.

Or to put it in the appropriate jargon, the risk weighting for mortgages was - and is - much lower than for corporate loans.

In the many hundreds of pages of Basel rules in their assorted iterations since the 1980s, each bank became an amalgam of hundreds of different leverage ratios, reflecting the perceived riskiness of the different categories of the loans it made and indeed of the age and size of the bank.

So, for example, a big bank that had been around for decades would be allowed to lend much more relative to its capital than a small bank (the big bank would have what's known as "advance" status).

And if that bank had substantial trading or investment banking activities, it was allowed almost total discretion to determine the riskiness of those activities and to hold as little capital as it liked.

Also, if a bank turned stinky subprime loans into AAA-rated bonds, again it could massage down the capital it needed to hold.

The Basel "incentives"

With good intentions on the road to ruin, regulators through the Basel rules were trying to provide a framework in which the risks and rewards of lending were properly captured.

In practice they did precisely the opposite: the Basel system provided the following arguably insane incentives:

1) banks had incentives to become bigger and bigger, to benefit from "advance" status that rewarded them with relatively lower capital requirements;

2) banks had a disincentive to know their corporate and personal customers, but instead had an incentive to insist that each loan was a mortgage backed by property - thus encouraging a dangerous boom in property lending;

3) banks had an incentive to become huge in trading loans and investments;

4) banks had incentives to convert risky loans into opaque AAA bonds that appeared - spuriously - to be safe.

In other words, regulation in the form of the Basel rules contributed directly to so much that is wrong with today's banks. It became harder for small banks to challenge big banks, because regulations disproportionately increased small banks' cost - which is partly why there is lamentably inadequate competition in banking today (many would say).

And the big banks could stick to the letter of the Basel rules and appear to be sound, when in fact they were massive, fiendishly complex and impenetrable institutions taking insane risks.

At the very instant that Northern Rock and Royal Bank of Scotland both collapsed and needed to be rescued, they looked the picture of health on the Basel measures. But each of them, on the simpler measure of gross leverage - that unweighted ratio of loans to capital - was a nano-distance away from the cliff edge.

RBS had lent 60 times its capital and the Rock had lent more than 100 times its equity capital. In other words, a fall in the value of loans and investments of less than 2% was enough to wipe out RBS's capital and losses of 1% mullered the Rock.

Under the cover of the Basel rules, RBS and the Rock took the kind of risks that no investor with half a brain would ever take (is it an unusual occurrence for the value of investments to fall by 2%?).

But nobody, especially the regulators, thought that RBS and the Rock were doing anything wrong, till it was far too late, because they were abiding by Basel rules.

They raided the cookie jar on an industrial scale, till they were morbidly obese, but their parents - the regulators - saw them as the picture of health.

The government's response

Now the 2008 Crash made it impossible any longer to pretend that the system of keeping banks on the straight and narrow was working.

But government's response has been a bit skewed and odd.

On the one hand, the collapse of the financial system has been taken as proof that bankers are incorrigibly, irredeemably naughty children.

By contrast, there is a presumption that the regulators who got it so wrong - the useless parents - can be redeemed.

One consequence is that the Basel rules that were so hopelessly flawed have been redrafted, and in the process have become even more complicated and impenetrable.

And regulators have been given more powers to interfere in banks, to supervise them, and deter them from misbehaving.

Some might say that the banks have been punished, and the regulators - who arguably were just as much at fault - have been rewarded.

But there is a bigger point, which is that if banks and bankers are infantilised to an even greater extent, you might wonder if they will ever grow up.

Which brings us back to where we started, the bloomin' gross leverage ratio. And it is to ask the question whether the global financial system, and the economies of developed countries like Britain, would be in such dire straights if banks had been subject to a simple leverage ceiling, limiting how much banks could lend in total, irrespective of the nature of their loans, as a multiple of their capital.

Such a rule would, for example, have made it very hard for RBS and its ilk to become quite so huge - and therefore quite so expensive to bail out for taxpayers.

As it happens, the Basel gurus are introducing a 33-to-1 gross leverage ratio - which many would see as a step in the right direction, but British MPs and lords on the standards commission think is too high. They want the chancellor to legislate for a lower ratio, of perhaps 25 to 1, and to give the Bank of England's Financial Policy Committee the power to vary the ratio, depending on prevailing financial conditions.

The chancellor is resisting, because he fears British banks would be put at an unfair disadvantage compared with foreign banks able to lend more relative to their capital. And he has a concern that building societies and mortgage banks would cut back on important lending to the housing market, in that they would be most immediately and directly affected by a cut in the leverage ratio.

All that said, some might argue that this important debate still misses the big point. Because any leverage ratio is being seen - in Basel and Westminster - as a backstop, or only a bit of background insurance in case the Basel rules prove inadequate yet again.

There is no serious discussion of the idea that a low leverage ratio should be the first line of defence, and that the Basel risk-weighting rules should be less prescriptive and more in the form of guidance.

The question is whether we might over time get the banks and bankers the economy needs - sounder, providing credit where it is really needed - if those banks and bankers were treated not as self-destructive infants but as teenagers trying more often than not to do the right thing.

Would it be criminally insane to trust the banks with more discretion about how they lend and invest, so long as they never breached a relatively low leverage ratio (which research indicates might need to be as low as 10 to one, and certainly no more than 20 to one)?

All of which is perhaps to point out that the terms of the debate about how to sanitise the bloated financial system have been set by a regulatory community whose legitimacy should perhaps have been destroyed but which still seems (amazingly?) to be in loco parentis.